When launching a new business, it is a good practice to set up a separate legal entity for the company, such as a limited liability company or corporation. Creating an entity generally allows you to protect your personal assets from business creditors, creates a formal legal structure for operating your business, provides tax benefits and typically makes your business more attractive to lenders and investors. The best structure for your business depends on the intended strategy of your new business venture, if you intend to raise capital from investors, and in many cases your tax strategy. With respect to your tax strategy, two common options are an S-Corporation (S-Corp) and a C-Corporation (C-Corp).
S-Corps and C-Corps are very similar. “C-Corp” is simply another term for a regular corporation, while “S-Corp” refers to an entity that is incorporated under Sub-Chapter S of the Internal Revenue Code for a specific tax status. Both require setting up a separate legal entity, which has the authority to enter into contracts, own assets and hire employees. Shareholders also have limited liability protection, meaning a creditor cannot seize their personal assets. A common misconception is that you an S-Corp is an entity type that you choose when you create your entity. Instead, it is an election made with the IRS governing how the business is to be treated for tax purposes.
To establish either type of corporation, owners must file Articles (or Certificate) of Incorporation with a state’s Department of State. Certain states, like Delaware, also require every corporation to have bylaws. Even if bylaws are not mandatory in your state of incorporation, it is generally a good idea to have a set of rules that govern the internal affairs and day-to-day operations of your company to avoid disputes in the future. It is equally recommended to adopt corporate resolutions, i.e., Directors’ Initial Resolutions and Shareholders’ Initial Resolutions, to approve all the initial actions taken by the incorporator, shareholders and/or directors.
Moreover, both types of corporations operate with a board of directors and have shareholders. Day-to-day management is handled by a CEO (or president) and executives. Pursuant to their bylaws, they must observe certain corporate formalities, such as having shareholders and board meetings, maintaining corporate records, preparing annual reports and other obligations.
There are some significant differences between the two types of corporations. The primary ones relate to taxation, shareholder restrictions and the availability of multiple classes of stock.
Entities with S-Corp status are subject to the following rules:
C-Corporations differ as follows:
The best entity depends on your priorities and goals for the business. C-Corps are easier to form as the default option. They also offer flexibility in ownership in that there are no shareholder restrictions and the company can issue different classes of stock. This can be helpful in allowing companies to give employees stock option incentives or attract various types of investors. It also makes it easier to be acquired by another company or go public in the future.
However, if you are intending to remain a small company, these benefits may not outweigh the tax ramifications. One big disadvantage of C-Corps is double taxation. However, to counter this, the company can deduct 100 percent of their charitable contributions on their corporate return up to 10 percent of the company’s income. In addition, C-Corps can deduct certain benefits from employees’ pay, such as health insurance, which may help them attract and retain employees.
S-Corps offer many tax benefits, but they also tend to be more heavily scrutinized by taxing authorities. Owners must take care to comply with all the rules for S-Corps in order to maintain their preferred tax status.
Additionally, the limitations on shareholders and classes of securities can make it more difficult for S-Corps to get investors and expand their business, especially outside the U.S. For business owners who are considering creating an additional class of stock going forward, S-corp might not be the optimal option. However, on the flip side, it can also make it easier to manage the company and seek input from the owners. S-Corporations tend to be a better fit for those who want owners to contribute to the company and are looking to remain smaller in size.
Choosing the type of entity for your business is an important decision which should account for both short-term and long-term goals. Before you move forward, consult an experienced attorney to discuss the pros and cons of the options and picking which option may be best for you.